This document discusses recognizing employee contributions through pay programs. It describes theories on how pay influences individual performance and lists common pay programs like merit pay, bonuses, profit sharing and their advantages and disadvantages. Effective pay strategies align pay with organizational goals using a balanced scorecard approach. Executive pay aims to incentivize outcomes through contingent pay. Communication and participation are important for process issues while the pay strategy should match the overall organizational strategy.

1. Chapter 12
Recognizing Employee
Contributions with Pay
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2. ©McGraw-Hill Education
Learning Objectives
LO12-1 Discuss how pay influences individual employees, and
describe three theories that explain the effect of
compensation on individuals.
LO12-2 Describe the fundamental pay programs for recognizing
employees’ contributions to the organization’s success.
LO12-3 List the advantages and disadvantages of the pay
programs.
LO12-4 Describe how organizations combine incentive plans in a
balanced scorecard.
LO12-5 Discuss issues related to performance-based pay for
executives.
LO12-6 Explain the importance of process issues such as
communication in compensation management.
LO12-7 List the major factors to consider in matching the pay
strategy to the organization’s strategy.

3. ©McGraw-Hill Education
How Does Pay Influence Individual
Employees? 1 of 6
Reinforcement Theory
• A response followed by a reward is more likely to
recur in the future
• High employee performance followed by a
monetary reward will make future high
performance more likely
LO 12-1

4. ©McGraw-Hill Education
How Does Pay Influence Individual
Employees? 2 of 6
Expectancy Theory
• Emphasizes expected rewards
• Focuses on the effects of incentives
• The main influence of compensation is on
instrumentality: the perceived link between
behaviors and pay.

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How Does Pay Influence Individual
Employees? 3 of 6
Expectancy Theory continued
• Intrinsic and extrinsic motivation
• Extrinsic motivation depends on rewards (such
as pay and benefits) controlled by an external
source
• Intrinsic motivation depends on rewards that
flow naturally from work itself

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How Does Pay Influence Individual
Employees? 4 of 6
Agency Theory
• The divergent interests and goals of the
organization’s stakeholders (principles and
agents)
• The ways that employee compensation can be
used to align these interests and goals
• Goal congruence and incongruence

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How Does Pay Influence Individual
Employees? 5 of 6
Agency Theory continued
• The principal must choose a contracting scheme
that helps align the interests of the agent with the
principal’s own interests
• Outcome-oriented contracts
• Behavior-based contracts

8. ©McGraw-Hill Education
How Does Pay Influence Individual
Employees? 6 of 6
Agency Theory continued
• What type of contract an organization should use
depends on
• Risk aversion
• Outcome uncertainty
• Job programmability
• Measurable job outcomes
• Ability to pay
• Tradition

9. ©McGraw-Hill Education
How Do Pay Sorting Effects Influence Labor
Force Composition?
Sorting Effect
• Individual pay programs may affect the nature and
composition of an organization’s workforce
• Linking pay to performance may attract retain more high
performers
• Personality traits and values

10. ©McGraw-Hill Education
Pay-for-Performance Programs 1 of 10
Differentiation in Performance and Pay
• Important to pay high performers an amount they
feel is equitable
Differentiation Strength/Incentive Intensity:
Promise and Peril
• Incentive intensity
• Strengthens motivation but also unintended
consequences
LO 12-2

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Pay-for-Performance Programs 2 of 10
Types of Pay for Performance
• Pay programs differ
• Whether payouts become part of base pay, are a fixed
cost, or are variable.
• Some programs measure performance using primarily
subjective measures, whereas others rely on more
objective performance measures.
• Performance can be measured at the individual level or at
the unit or organization level.
• Combination of programs may work best.

12. ©McGraw-Hill Education
Table 12.1 Programs for Recognizing
Employee Contributions
Design
Features MERIT PAY
MERIT
BONUS
INCENTIVE
PAY
PROFIT
SHARING
STOCK
OWNERSHIP/
STOCK
OPTIONS
GAIN-
SHARING
SKILL
BASED
Fixed
(becomes
part of base
salary) or
variable
Fixed Variable
(bonus)
Variable
(bonus)
Variable
(bonus)
Variable
(equity
changes)
Variable
(bonus)
Fixed
Performance
measure
(subjective
or objective)
Subjective
(usually
supervisor
rating)
Subjective
(usually
supervisor
rating), but
higher-level
jobs may
include
objective
components
also
Objective
(e.g.,
productivity)
Objective
(profit)
Objective
(stock
price/returns)
Objective
(productivity,
safety,
rework,
customer
satisfaction)
Objective
and/or
subjective
(certifying
which skills
are acquired)
Performance
measure
(individual or
collective)
Individual Individual,
but higher-
level jobs
may include
unit and/or
organization
outcomes.
Individual Collective
(organiza-
tion)
Collective
(organization)
Collective
(unit)
Objective
and/or
subjective
(certifying
which skills
are acquired)

13. ©McGraw-Hill Education
Pay-for-Performance Programs 3 of 10
Merit Pay and Merit Bonuses
• With merit pay, programs, annual base pay
increases are usually linked to performance
appraisal ratings.
• Merit bonuses may define and reward various
performance dimensions.
• Merit increase grid based on
• Performance rating
• Compa-ratio
• Distribution of performance ratings
LO 12-3

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Table 12.2 Performance Dimensions for Lower to
Mid-level Managers, Arrow Electronics
1. Exercises good business judgment
2. Inspires enthusiasm, energy, understanding, loyalty for
company goals
3. Attracts, grows, and retains outstanding talent
4. Shows initiative
5. Has position-specific knowledge
6. Delivers results
7. Builds internal good will
SOURCE: R. Riphahn, “Evidence on Incentive Effects of Subjective Performance Evaluations,” Industrial and Labor Relations Review 64 (2011).

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Table 12.3 Merit Increase Grid
RECOMMENDED SALARY INCREASES BY PERFORMANCE
RATING AND COMPA-RATIO
Compa-ratio
80-90%
Compa-ratio
91-110%
Compa-ratio
111-120%
Performance rating Blank Blank Blank
Exceeds expectations 7% 5% 3%
Meets expectations 4% 3% 2%
Below expectations 2% 0% 0%

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Table 12.4 Performance Ratings and
Compa-Ratio Targets
PERFORMANCE RATING COMPA-RATIO TARGET
Exceeds expectations 111–120
Meets expectations 91–110
Below expectations Below 91

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Pay-for-Performance Programs 4 of 10
Merit Pay and Merit Bonuses continued
• Characteristics of Traditional Merit Pay Programs
• They identify individual differences in performance, which
are assumed to reflect differences in ability or motivation.
• The majority of information on individual performance is
collected from the immediate supervisor.
• There is a policy of linking pay increases to performance
appraisal results.
• Feedback under such systems tends to occur
infrequently, often once per year at the formal
performance review session.
• The flow of feedback tends to be largely unidirectional,
from supervisor to subordinate.

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Pay-for-Performance Programs 5 of 10
Merit Pay and Merit Bonuses continued
• Criticisms of Merit Pay Programs
• It is unfair to rate individual performance because
“apparent differences between people arise almost
entirely from the system that they work in, not from the
people themselves.”
• The individual focus of merit pay discourages teamwork.
• If the performance measure is not perceived as being fair
and accurate, the entire merit pay program can break
down.
• Merit pay does not really exist.

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Table 12.5 Examples of Procedural Justice
in Merit Pay Decisions
Employees’ Belief That in Evaluating Their Performance, Their
Supervisor...
• Was honest and ethical and tried to be fair
• Considered your input
• Used consistent standards
• Provided feedback
• Took the time to become familiar with your role and
performance, including factors beyond your control
• After a merit pay decision was made, was receptive to
discussion of how the decision was made (and/or an appeal)
and working together to develop an action plan going forward

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Pay-for-Performance Programs 6 of 10
Merit Pay and Merit Bonuses continued
• Individual Incentives
• Payments not rolled into base pay.
• Performance is usually measured as physical output
rather than by subjective ratings.
• Rare because
• Most jobs have no physical output measure.
• Administrative problems
• Employees only do what they are paid for.
• Don’t fit with a team approach
• May be inconsistent with learning new skills
• May reward output volume at the expense of quality or
customer service
• May undermine motivation

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Pay-for-Performance Programs 7 of 10
Merit Pay and Merit Bonuses continued
• Profit sharing and ownership
• Advantages of profit sharing
• Employees think more like owners, taking a broad
view of what needs to be done to make the
organization more effective
• Labor costs are automatically reduced during difficult
economic times, and wealth is shared during good
times
• Disadvantages
• Most employees are unlikely to see a strong
connection between what they do and what they earn
under profit sharing.
• Most plans are deferred.

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Pay-for-Performance Programs 8 of 10
Merit Pay and Merit Bonuses continued
• Profit sharing and ownership
• Employee ownership
• Encourages employees to focus on the success of the
organization as a whole
• May not motivate in large organizations
• Employees may not realize any financial gain until they
actually sell their stock
• Stock options
• Employee stock ownership plans (ESOPs)

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Pay-for-Performance Programs 9 of 10
Gainsharing, Group Incentives, and Team Awards
• Gainsharing
• Measures group or plant performance
• Payouts are not deferred
• More motivating to employees
• Group incentives and team awards
• Typically pertain to a smaller work group
• May use a broader range of performance measures
• May demotivate top performers

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Pay-for-Performance Programs 10 of 10
Balanced Scorecard
• Use a mix of pay programs
• Balanced scorecard
• Balances multiple objectives
LO 12-4

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Managerial and Executive Pay
Agency theory perspective
• The goal of owners (shareholders) is to encourage
the agents (managers and executives) to act in the
best interests of the owners.
• More emphasis on outcome-oriented “contracts” that
make some portion of executive pay contingent on the
organization’s profitability or stock performance
• Balanced scorecard is necessary
LO 12-5

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Process and Context Issues 1 of 2
Employee Participation in Decision Making
• Linked to higher pay satisfaction and job
satisfaction
• Delegation of decision making can be costly
LO 12-6

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Process and Context Issues 2 of 2
Communication
• Deal with employee concerns
Pay and Process: Intertwined Effects
• Gainsharing can positively affect productivity

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Organization Strategy and Compensation
Strategy: A Question of Fit
Pay Strategy
• Important to consider how it will match the
organization’s overall strategies
• Best practices
• Choosing a pay level that balances the ability to
compete in the product market and in the labor market
• Paying for performance to obtain positive incentive and
sorting effects
• Paying attention to both distributive (e.g., equity theory)
and procedural justice issues
• Complying with regulatory requirements
LO 12-7